Conservatism

Definition:

Conservatism is a GAAP (generally accepted accounting principles) principle. The conservatism principle requires that losses be recognized as soon as they can be quantified and that gains are recorded only when they are realized. This principle is intended to protect the users of financial information from inflated revenue, profit, or asset numbers and make all potential costs, losses, or declines in value apparent as soon as possible.

Example:

If an asset owned by a company, such as inventory, was bought for $100 but can now be purchased for $60, the company must immediately write down the value of the asset to $60, the “lower of cost or market.” However, if that inventory item was bought for $100 and now would cost the company $140, it is still shown as $100 on the books. The gain is reflected only when the item sells.

Book Excerpt:

The PP&E (or Property Plant and Equipment) figure is the total number of dollars it cost to buy all the facilities and equipment the company uses to operate the business. Note that the relevant cost here is the purchase price. Without constant appraisals, nobody really knows how much a company’s real estate or equipment might be worth on the open market. So accountants, governed by the principle of conservatism, say in effect, “Let’s use what we do know, which is the cost of acquiring those assets.”

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